3.5 Profitability and liquidity ratio analysis

Profitability Ratio

Financial ratios that show the profit of a business in relation to other financial figures.

Gross Profit Margin

A profitability ratio that shows the gross profit as a percentage of sales revenue.

Gross Profit Margin Calculation

gross profit margin = gross profit/sales revenue x 100

Gross Profit Calculation

gross profit = sales revenue - cost of sales

Strategies to Improve Gross Profit Margin (improve sales revenue)

Diversification, Lowering prices, Increasing prices

Strategies to Improve Gross Profit Margin (decrease cost of sales)

Economies of scale,Using lower cost suppliers, Reducing direct labour costs

Profit Margin

A profitability ratio that shows the profit before interest and tax as a percentage of sales revenue.

Profit Margin Calculation

profit margin = profit before interest and tax/sales revenue x 100

Strategies to Improve Profit Margin (reducing expenses)

rent
electricity
stationery
administration costs

Return on capital employed (ROCE)

A profitability ratio that shows the profit before interest and tax as a percentage of capital employed.

Return on capital employed (ROCE) Calculation

ROCE = profit before interest and tax/capital employed x 100

Capital Employed

The value of all sources of internal and external finance for a business, calculated from the sum of non‐current liabilities and equity.

Capital Employed Calculation

capital employed = non-current liabilities + equity

Strategies to Improve return on capital employed

Increase sales revenue
Reduce cost of sales
Sell unused and obsolete assets
Reduce long-term liabilities
Reduce share capital and retained profit

Liquidity Ratios

Financial ratios that measure a business’s ability to settle its short-term debt obligation, comparing the value of current assets to the value of current liabilities.

Working Capital Calculation

working capital = current assets - current liabilities

Current Ratio

A liquidity ratio that measures the value of current assets relative to current liabilities, calculated by dividing current assets by current liabilities.

Current Ratio Calculation

current ratio = current assets/current liabilities

Good current ratio

between 1.5 to 2

Bad current ratio

below 1

Strategies to Improve current ratio (increase current assets)

Increase sales
Reduce debtors’ figures
Sell unused fixed assets

Strategies to Improve current ratio (reduce current liabilties)

extend credit period
decrease overheads

Acid test (quick) ratio

A liquidity ratio that measures the value of current assets without stock included, relative to current liabilities.

Acid test (quick) ratio calculations

acid test ratio = current assets - stock/current liabilities

strategies to improve acid test ratio

increase cash reserves

collect receivables faster

reduce current liabilities

sell unused inventory

avoid short term borrowing

Good acid test ratio

more than 1

Bad acid test ratio

lower than 1

uses of ratio analyses

anticipate pay changes
pay bills on time
predict returns on investment
evaluate ability to repay loans
anticipate job opportunities

Limitations of ratio analyses

historical data only, not current or future finances

affected by external changes

ignores qualitative factors like customer satisfaction and staff motivation

social enterprises may interpret ratios differently